Commentary: An ideal time for a hedged strategy

LawrenceG. McMillan

It is not unusual to see traders worry about what might happen to the market in the typically nasty September-October time frame, but this year, they're really getting carried away.

We can see, in mathematical terms, how much they're paying by looking at the implied volatilities of the S&P 500
SPX, +0.59%
options expiring in various months. These data show up in the prices of the CBOE Volatility Index
VIX, -7.04%
futures.

The premiums on the VIX futures are huge -- some of the highest readings in history. Table 1 shows the term structure, using closing prices of July 20. All seven months are included in Table 1, so that you can see how the term structure is constructed at this time. There is a healthy premium in August options (over 4 points). But the premiums are extremely large for September and October. After that, the remaining months are rather flat -- nearly the same price as October.

So the term structure rises extremely sharply from August through October, and then flattens out. If you consider what is causing this, it is traders paying up for SPX options expiring from September through November (the underlying "entity" for August VIX futures, for example, is the strip of SPX options expiring in September).

Obviously, those who are paying up for SPX options are likely buying puts and are worried about what might happen this year in the fall -- typically the worst time of the year for equity prices. Last year, there was something similar, but the premiums did not reach these heights.

Not only does the term structure have this steep upward slope now, but it has been retaining it for a few weeks now -- regardless of whether the stock market (SPX) rises or falls.

Strategy/speculation

From a strategy viewpoint, there are some conclusions that we can draw. First of all, when the term structure is this steep, historically, it typically comes at the end of a strong stock-market rally. That is, it is an indication that the market is overbought. Usually, the market then pulls back, and the term structure flattens out. The current heights were reached when SPX had a strong bullish run at the beginning of July, taking it to the 1,100 level. Since then, it has been unable to punch through 1,100, but it hasn't pulled back much either.

There is some precedent for this. Note that the current differential between VIX and the highest futures price is about 9 points. That's the highest/steepest on record (there were bigger futures discounts in the fall of 2008, but there have never been larger futures premiums). Two other times this year, the term structure became very steep. The first was in mid-January, when the differential between VIX and the highest futures price reached about 7 points. A severe market decline of 100 SPX points (intraday) followed very quickly thereafter. The second was in late April, when the differential reached 8 points at its steepest. SPX soon followed with a drop of 180 points.

So the steepness of the term structure is a short-term negative for stock-market outlook, if these precedents hold up. One can't take such data as "gospel," though, because each market is a bit different. For example, if the current premiums are strictly being caused by knee-jerk protective strategies because the fall of the year is approaching, rather than being caused by "smart money" buying protection near a market top, then the ramifications are different.

In any case, one strategy would be to buy SPX puts, figuring that the term structure is predicting at least a short-term market decline.

A less speculative strategy can be established as well. We have often written in the past about the hedged strategy of buying VIX puts and simultaneously buying SPY puts as a hedge. This is an ideal time for that hedged strategy.

The advantage of buying, say, September VIX puts is that the huge 6.87 point differential between VIX and the Sept VIX futures will have to disappear by September VIX expiration (in eight weeks). Remember that the Sept VIX puts are priced off of the futures, not off of VIX. So, if that 6.87 differential shrinks by the September futures falling from their current price near 31 to the current VIX price near 24, those puts would profit handsomely.

The problem, though, is that eight weeks is a long time, and we don't know where VIX might go in the interim. For example, if VIX rose to 31 over that time period, while the September futures remained unchanged, the differential would also shrink to zero, but your September VIX puts wouldn't have appreciated at all since September VIX futures were unchanged. The way to hedge that risk is to buy puts on the broad market -- SPX puts or SPY (the SPX exchange-traded fund) puts. In this way, if VIX does rise to meet the futures, surely the stock market would be falling, and the SPY puts would appreciate in value.

The ratio of how many VIX puts to buy and how many SPY puts to buy changes at different volatility levels. But, if one buys slightly in-the-money puts on both VIX and SPY, then a ratio of 5 VIX puts to 3 SPY puts is the proper one at the current time.

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